Should You Own Distribution, or Broker It?

Here is an interesting problem for businesses that want to establish markets.  Should they own all of the distribution chain, or should they broker it out and share the producer surplus with other entities?

The knee jerk answer is of course share.  You want network effects and they are easier to get when you share.  But the answer for each individual business isn’t so easy.  If customers are concentrated and easily reached, it might bring more long term value to the business to own the distribution chain.

Let’s use a real world example.

Back in 1999 the Chicago Mercantile Exchange ($CME) was going through it’s demutualization process.  I was on the strategic planning committee.  The exchange was member run.  It was changing into a corporate entity. Virtually everything was on the table because it was a 100 year old institution.  However, many of it’s business practices were there because “it’s the way we always did that”.

The exchange/brokerage industry is rife with various layers of distribution.  In each layer, someone pays a toll.  One of the layers in the CME distribution chain was the use of clearing firms to interact with customers.  We had a short discussion about a concept called, “disintermediation”.  What if CME got rid of all it’s clearing firms and all the customers went direct?  Certainly many of the operations already existed inside the organization to allow that to happen.

In CME’s case we concluded that it made zero sense.  Today if CME were to undergo a similar transition, it would make zero sense.  They have a well established chain of distribution with relationships.  The opportunity cost of cutting out the middlemen and going direct would be higher than the cost of tending the established chain of distribution.

But not all businesses are like that.  Sometimes, customers are highly concentrated.  In other businesses, the change in technology over the past several years has allowed better communication networks to be established.  With that change in tech, it’s easier to coordinate and it makes no sense to pay someone else for customer acquisition.

Take the travel industry.  In the days if you wanted to catch a flight you had to go through a travel agent.  With the web, you can go direct to the airline website and book a ticket anywhere in the world.  They even have packages on their website.  Certainly, layers of distribution persist.  Companies like Orbitz contract with airlines and broker deals.   The travel industry also has lots of choices for a flight, so aggregators can fill a void.  But, companies like Orbitz are under constant pressure to add a lot of value.  If they don’t, they are gone.

If you are in an industry with lots of layers of distribution, instead of figuring out ways to make processes more efficient, there might be a really big business that could be started by simply figuring out ways to eliminate the layers.